[1]Chapter 7 individual debtors with business debts and surplus income, beware! In Schlehuber v. Fremont Nat’l Bank & Trust Co. (In re Schlehuber),[2] the Eighth Circuit affirmed a Nebraska bankruptcy court’s order to convert an individual debtor’s chapter 7 case to chapter 11 — not under § 707‌(b), as commonly used in consumer cases with facts similar to Schlehuber — but under § 706‌(b). Section 706‌(b) states that “[o]‌n request of a party in interest and after notice and a hearing, the court may convert a case under this chapter to a case under chapter 11 of this title at any time.”[3] This article examines the reasoning behind courts’ decisions to grant or deny § 706‌(b) motions for involuntary conversion when the debtor is an individual with non-consumer debt. Surprisingly, in cases with similar fact patterns, courts have reached different decisions.

The Schlehuber Decision

The Schlehubers’ chapter 7 petition indicated that their debts were primarily business-related. According to their Schedule I, the husband, a software salesman, earned approximately $23,000 per month; the wife earned about $1,000. After expenses, the debtors’ disposable income exceeded $4,000 per month. One unsecured creditor, to whom debtors owed a personal guarantee of $250,000 from their failed real estate investment business, moved to convert the case to chapter 11 under § 706‌(b) based on this apparent substantial disposable income.

Shortly after the motion was filed, the debtors amended their schedules to show increased expenses, decreased income and negative net income. At the hearing, the creditor argued that significant disposable income did in fact exist, and that the amended schedules were inaccurate based on the husband’s actual pay history. The creditor argued that conversion would allow the debtors to rehabilitate their financial affairs while repaying creditors approximately $278,000. The debtors replied that the creditor — by focusing on their ability to pay — was circumventing § 707‌(b). The debtors urged the court to consider factors other than ability to pay; otherwise, § 706‌(b) would be indistinguishable from § 707‌(b). Conversion was futile, the debtors argued, because they had no business to reorganize and were unwilling to commit their post-petition earnings to a chapter 11 plan. However, the debtors did concede that the amended schedules were inaccurate since the schedules projected lower commissions than what the husband actually received.

The bankruptcy court found that substantial disposable income existed based on actual income, and converted the husband’s case since he was the primary wage-earner and the couple had separated. The Bankruptcy Appellate Panel (BAP) and the Eighth Circuit affirmed, finding no abuse of discretion.[4]

The BAP, whose opinion contained the bulk of the analysis, recognized that § 706‌(b) lacks guidance on how to determine when to convert a case, but stated that the decision was based on the following: (1) what will most inure to the benefit of all parties in interest[5] and (2) anything relevant that would further the goals of the Bankruptcy Code.[6] The bankruptcy court’s decision to convert primarily turned on ability to pay, which the BAP agreed was “logically a central consideration under § 706‌(b),” since plan confirmation is a goal in chapter 11.[7] As to the debtor’s argument that the creditor was attempting to circumvent § 707‌(b), the BAP found that this argument was irrelevant: “Nothing in § 706‌(b) suggests that a court may not focus on ability to pay ... where the Debtor is an individual with primarily business debts.”[8] The court further opined that the debtor failed to show that ability to pay was not the most important factor.[9]

Conversion under § 706(b)

Conversion from chapter 7 to chapter 11 pursuant to § 706‌(b) is a contested matter, and the movant must prove that conversion is warranted.[10] Section 706‌(b) permits conversion to another chapter only where the debtor meets the eligibility requirements of that chapter.[11] This provision requires a notice and a hearing, is available to any interested party and only allows conversion to chapter 11.[12] Chapter 11 debtors lose the discretionary right to convert their case to chapter 7 if the case was converted involuntarily.[13] Few cases discuss § 706‌(b), and most involve high-income-earning professionals, such as physicians and corporate executives.

Courts unanimously follow the two-step analysis employed in Schlehuber when deciding whether to convert under § 706‌(b).[14] First, the decision to convert is in the sound discretion of the court, based on what will most inure to the benefit of all parties in interest.[15] Second, courts consider anything relevant that would further the goals of the Bankruptcy Code.[16] A court’s decision to convert will not be overturned unless there is abuse of discretion. A court abuses its discretion when it “relies upon a clearly erroneous finding of fact or fails to apply the proper legal standard.”[17]

Several courts reasoned that § 706‌(b) is intended for business debtors; therefore, individual chapter 7 debtors cannot be forced into a repayment plan.[18] A New York court also contemplated what is “fair and equitable” in a particular case, guided by the spirit and purpose of the law.[19] Hon. Roy Babitt noted that “Congress did not give creditors the unfettered right to insist on conversion ...; by leaving this decision to the court’s discretion, the court is free to explore ‘what is below the surface of the statute and yet fairly part of it.’”[20] Judge Babitt further stated:

The policy against forcing an individual to work against his will is applicable, if the facts present themselves, in chapter 11 as well as in chapter 13. Congress’‌[s] concerns are so strongly expressed in connection with chapter 13 that this court would be remiss were it to apply them only there.[21]

Involuntary Conversion Granted

In deciding what will benefit the parties and further the goals of the Bankruptcy Code, courts granting § 706‌(b) conversions tend to consider three factors: (1) whether the conversion would enhance the estate; (2) whether interested parties would benefit from conversion; and (3) whether the debtor could fund a chapter 11 plan.[22] In addition, one court also considered § 1112‌(b) factors, including whether cause existed to reconvert to chapter 7, the purpose of the conversion and whether a confirmable plan was possible.[23] Some courts decline to consider feasibility, finding that those issues are more appropriate for the confirmation hearing.

Courts ordering § 706‌(b) conversions typically find that conversion maximizes the estate due to the availability of the debtor’s post-petition wages in chapter 11.[24] Creditors also benefit by receiving a greater distribution in chapter 11. In cases in Florida and Georgia, the courts found that conversion would actually benefit the debtors by providing them with an opportunity to repay their creditors’ likely nondischargeable claims.[25] The Florida court noted that “courts generally consider whether the debtor has sufficient disposable income to fund a Chapter 11 plan.”[26] Conversion was allowed notwithstanding that a number of the debtor’s expenses were unreasonable or hypothetical.[27]

The Georgia court applied the § 1112‌(b) factors and determined that re-conversion to chapter 7 was unlikely since the debtor demonstrated a consistently high income and no other § 1112 “cause” for conversion applied.[28] The court stated that “[c]‌onversion to Chapter 11 is an appropriate remedy provided by Congress for a non-consumer debtor with an ability to pay to avoid the same abuses of the bankruptcy system identified in the consumer area.”[29]

The Fifth Circuit granted reconversion under § 706‌(b) on the basis of bad faith. In Matter of Texas Extrusion Corp.,[30] the debtor demonstrated questionable motives in converting her case from chapter 11 to chapter 7 one week before the confirmation hearing. The court found that the debtor’s primary purpose in converting was to interfere with the chapter 11 reorganization.[31]

Involuntary Conversion Denied

In two cases, courts refused to convert when no “cause” existed, wherein conversion failed to benefit the debtor, or where the movant’s primary objective was to force the debtors to repay the creditors.[32] Even the debtor’s lavish lifestyle and errors in the petition were insufficient to constitute “cause.”[33] In Quinn, a New Mexico court noted that at first blush, the debtors did not appear to be the type to require chapter 7 relief, but reiterated that a principal goal of bankruptcy is to provide a fresh start to the “honest-but-unfortunate debtor” and pointed out that the debtors had suffered misfortune.[34]

Likewise, in Lobera, a New Mexico court denied conversion even where the estate would have been maximized.[35] In balancing the parties’ interests, the court found that conversion would only benefit the creditor. The debtor would have been trapped in chapter 11, unable to automatically reconvert his case to chapter 7.

Involuntary Servitude?

Few courts have addressed the issue of involuntary servitude in the context of § 706‌(b).[36] In consumer cases, courts have refused to grant a motion to convert an individual debtor’s case where the movant’s intent was “to compel the debtor to submit to an involuntary repayment plan.”[37] Courts analyzing § 706‌(b) in this framework disagree on whether a constitutional issue exists.[38]

The Georgia court found that “mere conversion” was not involuntary servitude since conversion alone did not mandate the debtor to work or pay his creditors.[39] The court explained that “the involuntary servitude standard is not so rigorous as to prohibit all forms of labor that one person is compelled to perform for the benefit of another” and further explained that “[t]‌he Thirteenth Amendment does not bar labor that an individual may, at least in some sense, choose not to perform, even when the consequences of that choice are ‘exceedingly bad.’”[40]

Conclusion

The common thread among the rationales is that a bankruptcy court is empowered with the discretion to decide whether to convert. To date, no circuit court has overruled a bankruptcy court’s decision on a § 706‌(b) motion. The lesson from Schlehuber is this: A § 706‌(b) battle is won or lost in bankruptcy court, so while you are there, be prepared to put up your best fight either for or against conversion. If you lose at trial, you are likely to lose on appeal, like Mr. Schlehuber.

[1] The views expressed herein do not necessarily represent the views of the U.S. courts.

[20]Id. (citation omitted); see In re Graham, 21 B.R. 235, 236 (Bankr. N.D. Iowa 1982) (noting that appropriateness of § 706‌(b) conversion depends on Congress’s concerns when it adopted Bankruptcy Reform Act of 1978: “In adopting the Bankruptcy Reform Act of 1978, Congress did not intend [that] individual debtors be compelled to submit to the terms of a repayment plan”).

[21]Matter of Noonan, 17 B.R. at 800; but see In re Gordon, 465 B.R. 683, 697 (Bankr. N.D. Ga. 2012) (stating that “[w]‌hen [an] employee has a choice, even though it is a painful one, there is no involuntary servitude.... A showing of compulsion is thus a prerequisite to proof of involuntary servitude”) (citation omitted).

[33]In re Quinn, 490 B.R at 613, 621 (quoting In re Huckfeldt, 39 F.3d 829, 832 (8th Cir. 1994)) (“[T]‌he bad-faith inquiry will be ‘employed as a loose cannon, which is to be pointed in the direction of a debtor whose values do not coincide precisely with those of the court.’”) (citation omitted).